High Frequency Trading Is Poison In The Bloodstream Of Markets

If you read the Bullworthy.co m blog with any regularity, you've had a handful of basic investment concepts and fundamental guidelines hammered into your brain; the simplest reason being is that repetition creates habit, and habit creates success. All too often human nature displays a selfish squandering of humility, and the average person just never learns. If you're having a hard time understanding what a stock is, don't stop studying until you get it. If you're buying a stock because it's up 32%, and it losses half its value three days later, stop trying to capture momentum plays. And if you really want to understand what the companies of the future are going to look like, you have to accept the idea that the playing ground for investors is no longer level.

I read all the time about technical analysis and how it drives (by tremendous measures, actually) how and what a trader trades in any particular day. We see a flashy E*Trade commercial, and the most emphasized feature is always some new, glamorized technical gadget - a "world-indexed heat map", for example - that probably no one really needs. But there is a darker side to technical analysis we haven't fully yet felt, although I think we were recently brushed by its massive capabilities.

With the advent and explosive proliferation of the Internet and it's widespread ability, coupled with the government's deregulation of brokerage and security firm's commission fees that gave birth to the discount broker, it seems like everyone is a stock-trading guru. I'm pretty sure my grandfather trades Ford stock from his kitchen table every morning, and I can't do a YouTube search for the words "stock", "market", or a combination of both without returning at least 985 trillion hits of user-generated videos of nerds explaining how they trade $76 worth of some cheap penny stock.

I'm a big advocate of the free market system and free speech, but does everyone have to be entitled to those virtues? And since the answer is presumably "yes" (I'm an equal-opportunity learner, after all) can we at least recognize our weakness and limitations?

High-frequency trading was developed in the early 2000's by teams of computer software programmers and mathematicians. The goal was to be able to shave off a fraction of a second (and at the same time, add to the price a fraction of a penny) to an electronic market order for a stock that was either being bought or sold by a retail investor using his online brokerage account, and then do repeat the transaction millions of times a day. Since then, high-frequency trading has come under direct assault from the Securities and Exchange Commission, advocacy groups, and finance journals like Money Magazine in full-spread feature articles and cover stories.

But we still haven't got it yet. The controversy is based on the existence of an uneven playing field; that high-frequency traders have unparallel access to market inefficiencies and expose pricing vulnerabilities in a profoundly successful manipulation of liquidity.

As a result, it's the retail investors that think just because they've made a few hundred bucks since they've started "day-trading" that they are indestructible experts. This dangerous mentality is so far from reality that maybe the only way we will all learn from the dangers in allowing the gap between the investment haves and have not's is to actually experience them.

In early May of 2010, the Dow Jones Industrial Average plummeted nearly 1,000 points in one of the most gut-busting, nerve wrecking fifteen minutes in the history of financial markets. The initial reaction reported in the press was that the drop had been an accident of the proverbial "fat-fingered trade", a typo in the marketing orders that are placed by NYSE floor traders using electronic terminals. "Perhaps someone simply pushed 'B' for billion, when they meant to push 'M' for million" they printed. I immediately put up a blog post on Bullworthy's homepage that warned the drop was more likely an unknown effect of the pervasive high-frequency traders and dark pools in which they operate.

A few weeks later, the Wall Street Journal ran an article essentially confirming exactly what I have been suspecting. You can find the Bullworthy article threads here and compare the dates.

The investor playing field has been tampered and recalculated by smart, powerful, and resourceful traders who will always be employing new systems to make bucks off of gullible retail investors who think they can beat markets. For one, I would have to say that I'm not going to challenge these guys. While I don't feel conformable making predictions, I've got a feeling we haven't seen the end of the high-frequency trading poison seeping into the bloodstream of our worldwide economic and financial markets, and I'll prefer to keep my distance.